Snakes in the grass?

In a recent contribution to the Financial Times (Insight: Time will judge the Fed’s rate moves), Richard Yamarone, chief economist at Argus Research Corp. in New York, argues that Fed inside information about an as yet unrevealed financial calamity may have been the reason for the recent sharp cuts in the Federal Funds target rate – 75 basis points on January 22 (the announcement was made out of normal hours and not on a day scheduled for a regular FOMC rate-setting meeting) and 50 basis points on January 30. His argument follows.

“This all said, we suspect that there is something more disconcerting looming in the financial markets encouraging this pace of rate cutting. Promoters of full employment and price stability do not forcefully cut rates on an inter-meeting basis in hope of staving off an economic recession that hasn’t convincingly surfaced in the data. Changes in monetary policy move with long and variable lags – upwards of twelve to eighteen months – so moving a week earlier is meaningless for economic reasons.

Quite possibly, a big bank or financial institution may be in dire straits or on the verge of failure. Somebody may have gone to the Fed and said, “We’ve got a critical disease and we’ve slept with the world, you guys better deal with it.” That’s a pretty reasonable explanation for the ensuing change in policy.

It’s too soon to say whether or not these were prudent or foolish moves. If in fact there is some calamity looming that only those around that 27-foot Honduran-mahogany table at the Federal Reserve are aware of, then this stimulus will be more than justified. It is indeed a priority to insure a proper functioning of the banking system.”

The argument does not make sense. Not because I believe that there is no big bank or other financial institution at risk of going under or even about to do so. While I don’t have any inside information on the matter, there may well be such tottering entities, either in the US or in Europe or both. It would be remarkable if the massive mispricing of risk of the past five years and the associated reckless borrowing, careless lending and imprudent investment were not to result in the demise (or bail-out) of some household-name internationally active bank or other financial institution.

The reason it does not make sense is that a cut in the target for the Federal Funds rate is a completely inappropriate and ineffective instrument for addressing (the threat of) a serious banking failure or similar financial calamity. The Federal Funds target determines the short (overnight) (default-)risk-free nominal interest rate. No bank that is about to go belly-up would be helped materially by a reduction of 125 basis points in the risk-free overnight rate of interest. What is killing the bank are losses on its assets and the inability to refinance its maturing liabilities because the default risk spreads and liquidity risk spreads it faces have become prohibitive. A cut in the level of the overnight risk-free rate would not have a first-order effect on liquidity risk and credit risk spreads. It has delayed economy-wide effects on solvent institutions, but does not help those on the edge of insolvency.

(1) A lender of last resort (the Fed in the US) willing to take its illiquid collateral in exchange for liquid funds. It can only hope to gain access to LoLR funds (at a penalty rate, with its illiquid assets valued for collateral purposes at a punitive price and subject to a further liquidity haircut) if, in the judgment of the LoLR, its assets have sufficient fundamental value. The LoLR need be concerned only with the underlying fundamental value, in orderly markets, of the assets offered as collateral, because unlike the troubled bank, the LoLR is not constrained by short-term illiquidity problems. This will work of the troubled bank is illiquid but not insolvent.
(2) A bail-out, that is, an injection of private or public funds to recapitalise what has become an undercapitalised institution. A private sector bail out or ‘solution’ could involve or lead to a take-over of the afflicted institution, or to some other form of financial and/or organisational restructuring. A public sector bail-out would mean tax payers’ money is put at risk. In the case of a bank, it could mean that the troubled institution is placed in a Special Resolution Regime for troubled but pre-insolvent banks of the kind operated by the FDIC and now proposed for the UK by the UK Treasury.

A public sector bail-out should only be undertaken for a systemically important institution. I have never yet encountered a bank or other private financial institution that is systemically important in a financial system with proper deposit insurance and a sensible bank insolvency resolution regime. It could mean taking the troubled institution into temporary public ownership (that is, nationalisation).

Or it could mean the bank entering the special bank insolvency process to be liquidated. The original shareholders should be at the end of the queue of claimants on the proceeds from the sale of the assets of the insolvent bank. The management should be sacked without a handshake of any kind, let alone a golden one.

(3) Insolvency and liquidation (see the last paragraph of option (2)).

To use an instrument designed for making monetary policy, a process involving long, variable and uncertain lags, to mount a rescue operation for a failing bank or other financial institution – a purpose for which it is not designed and to which it is unlikely to make a material contribution – makes no sense. I don’t believe that the Fed would consider it, let alone do it.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.